Bruce Bennett
Shares of Gap (NYSE:GPS) have been on a strong run recently, essentially doubling since May, moving them solidly into positive territory over the past year. Still, shares have lost nearly half of their value in the past five years as the company has struggled to reinvent its brands and keep them relevant for a new generation of consumers. However, on Thursday, the company reported really solid earnings that sent shares up over 10% immediately in response. It seems like Gap’s momentum is continuing, and the turn is coming.
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In the company’s third quarter, Gap earned $0.59, beating consensus by $0.39 as revenue fell by 5.9% from last year to $3.8 billion ($190 million ahead of estimates). The sale of its China business accounted for about 2% of that drop with GAP’s same store sales down by just 2%. If there was one disappointment, it was that online sales were down 8% and 38% of total sales, a sharper decline than the overall business. It is interesting to see that Gap’s brick and mortar stores actually outperformed its online presence, especially given worries about the death of malls where many of its locations are based.
On the positive side, not only are comps getting less negative, but each sale is becoming more valuable for shareholders because gross margin rose 260bp to 41.3%, adjusting for the impairment of the Yeezy business last year. Some of this was offset by the fact that operating expenses were down by a more modest 1.5% as some of its cost-base, like rents, are fixed. Still, adjusted operating margin was a solid 6.8%.
Gap is generating better gross margins because the company is being less promotional. That is driven by the fact management has fixed its inventory problem. Last year, as consumer spending slowed, it was significantly overstocked, and so management cut prices to move product out of its store. It was painful for margins, but that has left its balance sheet and business in a much healthier position. Inventories are down 22% from last year. That is a 16% sharper decline than sales or about $500 million less product, relative to sales.
As a result of this, Gap’s cash on hand has doubled from a year ago to $1.35 billion. Gap has generated $544 million of free cash flow this year, and $427 million excluding working capital. Based on Q4 guidance, working-capital adjusted free cash flow should end the year north of $600 million. Thanks to inventory management, Gap has more cash on hand, and it has less need to be promotional, preserving more margin on each sale.
Now, the reason Gap was carrying more inventory than it should have is clear. As you can see below, apparel consumption soared after the pandemic as people began traveling and working in person, not to mention the excess savings they had to spend. As a sector, retailers grew too optimistic that this growth would continue, when in reality apparel consumption moved well above the pre-COVID trend.
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As inflation spiked and disposable incomes were squeezed, apparel spending flatlined, leaving retailers like Gap with more inventory than they needed as anticipated growth did not materialize. Importantly, because consumption has flatlined, its annual growth rate since the end of 2019 is slowing and converging toward the previous trend. Apparel spending is only up about 4% annualized from pre-COVID levels, not far above the ~3% pre-COVID spending trend. This means we are nearing the point where consumers are spending “what they should be” on clothes, at which point spending can once again start rising in a sustainable way.
The primary risk to my view of resumed growth next year after a prolonged period of trending water would be that we have a recession. After all, in recessions, consumers pull back on discretionary items, like apparel. In this discussion, it is important to remember that while Gap operates in 40 countries, the US accounts for 86% of its revenue. Right now, the US consumer does not show signs of a recession; certainly not with the earnings Gap, Macy’s (M), and Target (TGT) delivered. Moreover, unemployment is low, and wages are rising. Plus, oil prices have fallen over the past month, providing some relief on inflation.
I often get push back that US consumers are overspent and now have borrowed too much, given record credit card debt. I push back on this view, though. Yes, credit card balances are higher than 2019, but so is personal income. What matters most is debt relative to income. In fact, credit card debt is slightly lower than 2019 levels relative to incomes, and the 2019 economy was a pretty good one. Debt has come back to normal levels, but it is not at a distressing level. This is why I expect consumers to keep spending.
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Digging back deeper into Gap, the company is still seeing wide variation in performance by brand. Now despite its name, Old Navy is actually about 60% of the business. Critically, its biggest unit is also its best performing one. Revenue was down just 1% from last year as activewear accelerated, and women’s apparel is strong. Same store sales were actually up 1%. This was a really encouraging performance
In the middle of the pack, Gap store revenue was down 15% to $887 million, but it was down a more modest 6% excluding the divestiture of Gap China. Same store sales were down 1%, getting close to turning positive as underperforming locations have been closed.
Unfortunately, the company’s two niche brands continue to struggle. Banana Republic was down 11% to $460 million with comps down 8% as its shift to a more premium customer remains challenging. Essentially, it seems like Banana Republic may have become too premium for some of its existing customers while not sufficiently aspirational to bring in new premium customers. Its activewear brand, Athleta, was down 18% to $279 million with comps down 19%. Last year, Athleta was particularly promotional as it moved through excess inventory, but this was still a difficult result. This unit has simply struggled to compete with Lululemon (LULU).
These two brands account for less than 20% of sales, and with their declines, they are becoming less relevant to the company’s financials. I do not expect more divestitures, but I do think a sale of Athleta in particular to return focus to the company would be well received. This is an upside risk, but not a likely one, as management will likely first try to turn these units around as they have successfully done with Old Navy, at which point valuations could be more attractive. I am not expecting much improvement from these units, and believe they are still a “show me story.” However, Old Navy has returned to growth, and Gap may post positive comps in Q4. Those turnarounds now have shown results, and that has boosted management’s credibility significantly. Alongside earnings. the company reaffirmed its revenue outlook. In Q4, they expect sales flat to slightly down relative to last year’s $4.2 billion (this does include a ~3.6% benefit from an extra week in the quarter). Cap-ex will also come in lower than expected at $475 million from $500-$525 million due to fewer store openings.
Gap also has a healthy balance sheet with just $1.5 billion of long-term debt, against $1.35 billion in cash, and $3.5 billion of operating lease liabilities, which are largely offset by $3.2 billion in operating lease assets. With this balance sheet and over $600 million in run-rate free cash flow, its $0.15 dividend is safely covered. Indeed, with $400 million in free cash flow retained after its dividend, GPS will move into a net-cash position over the next year. That actually opens the door to a potential share repurchase program sometime in 2024.
In a span of about 24 months (from mid-2022 to mid-2024), Gap will have gone from having to blow out significant excess inventory to having brought its balance sheet and operating income to a point where it can start enhancing shareholder returns. This has been driven by stabilization at Old Navy and meaningfully better gross margins. That is a testament to management’s turnaround efforts. Moreover, with consumers likely to continue spending, this turnaround should retain momentum at the corporate level even if Athleta and Banana Republic struggle.
As investors start thinking about more capital returns, that is likely to carry further momentum for shares. This company, just assuming stabilization here has about $1.6-1.65 in free cash flow per share, giving shares a roughly 10.5% free cash flow yield even with its rally after-hours. If my view that buybacks and/or a dividend increase begin entering the conversation next year, I think shares can move towards $20, or about an 8% free cash flow yield. If management can do for its small brands what it has done for Old Navy, there could be further upside. Yes, Gap has recovered a lot, and it is not too late to get long.
